Why the First Post-Salomon Scandal Refuncing Auction Didn’t Go So Well

DAN BLAKENovember 11, 1991

NEW YORK (AP) _ Ordinary government bond brokers were allowed to rub elbows for the first time with Wall Street’s club of primary dealers this past week in the government’s quarterly refunding auction.

But few market observers and participants feel the new Salomon-scandal inspired bidding rules were to blame for the three-day auction swinging from dismal to successful.

Rather than new rules, the overbearing presense of lawyers and in-house compliance officials led to tentative bidding and poor auctions Tuesday and Wednesday, market participants said. By Thursday, however, customer demand for the 30-year bond was so improved, bidding grew more aggressive, they said.

Still, some observers said the Treasury’s new rules led to confusion as primary dealers and investors bid tentatively because they weren’t sure how they would affect the auction.

″We’re going through a kind of shake-down cruise,″ Sung-Won Sohn, chief economist at Norwest Corp., said after Wednesday’s auction. Kathleen Camilli, chief economist at Ramirez Capital Consultants Inc., said there was some confusion earlier in the week.

However William V. Sullivan, director of money market research at Dean Witter Reynolds Inc., said the new rules were not a factor. If anything, they should have helped the auctions, but introducing more bidders to the process, he said.

Tuesday’s auction of three year notes was roundly judged a poor sale, with a slim ratio of bidders to winners and the government having to reach lower than normal into the bids to sell all the notes.

Wednesday’s auction of 10-year notes didn’t fare much better. Part of the reason, brokers say, was the surprise drop in the Federal Reserve’s discount rate loan fee to banks during the auction. The timing of the Fed move left traders more uncertain, which may have dulled their appetite for buying.

On Thursday, however, sentiment had swung around with demand the strongest in four years and only about 40 percent of the bidders were able to get their hands on bonds.

Demand picked up when bond arbitragers, who had been short on the issue, moved frantically to cover their positions and limit their losses, Camilli said.

By shorting the bonds, or selling borrowed bonds, arbitragers had bet prices would fall. They had hoped to buy them back at cheaper prices, replace the bonds they had borrowed and capture the difference as profit.

Signs of strong demand for the 30-year bond emerged Wednesday afternoon when the results of the 10-year auction were released. Demand rose, rather than fell, after news of the 10-year note’s poor showing.

Participants said the hightened scrutiny of the $2.3 trillion government bond market has stifled the routine discussions between dealers and customers.

Before the Salomon scandal, which uncovered several instances of cheating by the big broker at bond auctions, dealers would frequently discuss with each other how much interest they and their customers had in new Treasury debt.

Dealers would use the information to gauge the demand and help them determine the size of their bids. Now, however, regulators and lawmakers have suggested such discussions could amount to collusion.

Without the discussions, however, market participants said it is much more difficult to get a feel for the market, so they bid less aggressively.